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Don’t be blinkered with investments

Tracker funds cannot avoid the risk of being ‘overweight’ in overvalued shares — but managers cannot use this as an excuse

Words are cheap but when it comes to investment, it’s where people put their cash that counts. So those seeking money-making ideas — other than backing a long-odds winner in next Saturday’s Grand National — may find that it pays to watch what the experts do more than what they say.

Fortunately, most funds, such as unit and investment trusts, regularly report how they allocate assets. Most importantly, fact sheets and independent websites, such as FE Trustnet, list each fund’s top 10 shareholdings.

Among other things, this information shows which fund managers follow the herd and which merely replicate stock market indices while imposing fat fees for “stock selection”.

Sad to say, quite a few charge for more than they deliver. That’s what got me into DIY investing about 20 years ago.

For example, noticing how many UK equity income funds held oil, bank and mining shares because of their high yields made me think: “I can buy Royal Dutch Shell, HSBC and BHP Billiton for myself without any annual fees for holding them.”

True, their share prices and dividends have plunged since then, but at least I am not paying some “stripy shirt” thousands of pounds a year to make my mistakes for me.

No 8 and No 10 in that list show I am happy to pay for active fund management in areas where specialist knowledge clearly adds value. Despite widespread cynicism about stock-pickers, new research from the wealth manager Tilney Bestinvest shows that actively managed pooled funds often do deliver worthwhile returns.

Three years after regulatory intervention boosted the popularity of passive funds, which aim to track an index, many are being left in the dust by actively managed funds that rely on stock selection.

The average fund in the UK All Companies sector beat the FTSE All-Share index, a broad measure of shares listed on the London Stock Exchange, by more than five percentage points over the past three years. The average fund in the UK Equity Income sector beat the All-Share index by nearly 10 points over the same period, according to Tilney Bestinvest.

All these calculations take account of charges and include dividends reinvested. Jason Hollands, the managing director of Tilney Bestinvest, told me: “Tracker funds actually did marginally worse than the index because they have running costs the index does not have. It is ironic that three years after the regulators focused the spotlight heavily on costs, nearly doubling the amount invested in passive funds from £59bn in 2012 to £108bn last year, this has proved a dreadful investment strategy.”

He added: “Passive investing is no panacea as investors have been fully exposed to many big companies that cut dividends. With a very uncertain outlook for the global economy, it can pay to be in funds where managers can take a more selective approach to the companies in which they invest. The higher costs compared to tracker funds may be well worth paying where they can deliver better returns.”

Most stock market indices are influenced by past performance, which is not always the best way to bet on the future. So trackers tend to buy high and sell low — always the best way to turn a small fortune into a smaller one. For example, trackers were full of oil, bank and mining shares before those sectors plunged.

A tracker is like driving on a road you’ve never been on, looking only in the rear-view mirror

If that sounds a bit dry and technical, then let Alan Steel, founder of the eponymous Scottish asset management firm, put it in plain English: “Investing in a tracker fund is like driving along a road you have never been on before, looking only in the rear-view mirror.

“Capital-weighted indices, based on the total value of each company’s shares, are seriously flawed indicators of future returns because they are overweight in overvalued stocks and underweight in undervalued stocks. By contrast, the best way to invest is to pick managers who buy undervalued stocks, hold them until they are overvalued and then sell them.

“Who’s daft enough to buy those overvalued shares then? Tracker funds, of course. But most financial commentators bang on about costs and how you cannot beat the index — without bothering to identify which fund managers have done so.”

Exclusive research identifying the top 10 fund management companies that most consistently outperformed the market over the past five years has been promised to me for next week’s column. I will also look at the top individual funds over that period, too.

Having seen an early draft, I can promise several surprises, with little-known firms at the top of the table and many household names absent.

The way that low-cost tracker funds lag behind actively managed funds shows that cheap is not necessarily the same as good value.

Investors should always aim to buy low and sell high. Where that theory proves difficult to put into practice, it may make sense to pay for the services of a professional fund manager — but don’t forget to look under the bonnet and check you are getting value for money.Double the family fortune and beat death taxHow can parents who have cash to spare help their grown-up children onto the housing ladder and double their family wealth, courtesy of last month’s budget? Here’s how, according to Bob Rothenberg of the accountancy firm Blick Rothenberg.

Parents can use the “gifts out of income” exemption for inheritance tax (IHT) to help adult children make use of the new lifetime Isa, dubbed the Lisa, which will be available next year for 18 to 40-year-olds. This little-known exemption has no financial upper limit, nor any requirement for donors to survive their gifts for any minimum period.

If the parents funded the maximum Lisa contribution of £4,000 a year for seven years, it would cost them £28,000. That would cut their liability for IHT — levied at 40% — by £11,200.

So the net cost to the family would be £16,800, but the government top-up of £1,000 for every £4,000 put into the Lisa would lift the value of the savings to £35,000, even if there were no investment growth. Not a bad return on what could be risk-free bank deposits.

The only snags are that gifts out of income are exempt from IHT only if the donor can afford to make them without reducing their standard of living, and they must be part of “normal expenditure”, so it helps to keep records to show that you are regularly giving away money, in this case to your child’s Lisa. They can be funded from the donor’s earnings, pensions and savings interest, but not from capital.

Bob has been a governor of a school in north London for 18 years, so knows more than most about how older generations must help younger ones. For parents with assets above the death-tax threshold of £350,000 per person and adult children looking to buy a home, what’s not to like about Lisa-linked IHT planning?

A word from Edward

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